61. I would like to welcome our two witnesses
this morning on behalf of the Sub-Committee. They are, in alphabetical
order, Dr Schmieding, Chief European Economist at the Bank of
America, and Professor Thygesen of Danske Bankof course
known, I think, to members of the Sub-Committee as a member of
the Delors Committeewho has been very closely involved
in all these matters for a considerable number of years. Welcome
to the Sub-Committee. As you know, we are doing a report on the
European Central Bank, in particular on the way it has operated,
and it is now proposing to change the two pillars, and also on
the decisions that have been reached by the bank and the governments
as to the post-enlargement institutional provisions. That is the
broad outline. You have very kindly given us some useful material
on your own reactions to the changes by the ECB and the way it
is approaching the two pillars. It is really welcome to us that
we have your views on that, because it enables us to move into
the question and answer phase pretty promptly, but I wonder if
I could ask you before we start if you would be prepared just
to give a rather broad-brush analysis from your points of view
of how the bank has performed in the four years that it has been
so far functioning. What do you feel are its strengths or its
weaknesses? I am aware this is on the record and we are not talking
about whether or not the bank makes a change in interest rates
this week or what-have-youI mean, that is clearly something
on which we are not focusing, it is not our job tobut it
would be helpful if you could be as frank as possible in your
views because we are trying, among other things, to fit our inquiry
into a broader framework, which has to include an analysis of
how well the bank has performed in the period it has been in existence.
Perhaps I could ask each of you, if you are willing, to give us
a reaction to that general point, then the floor will be open
and I think we might proceed by first of all discussing the two
pillars, then discussing the institutional arrangements, and then
perhaps a few words about the issue of how this fits with economic
governance.

(Dr Schmieding) Perhaps I may start with
a personal word. By background I am a German euro-sceptic. A few
years ago, in late 1998, I clearly was not in favour of abolishing
the Bundesbank for the sake of the ECB. But I must say that my
euro-scepticism has mellowed a bit over time. One of the reasons
is of course that the ECB has definitely not lived up to what
were the worst German fears, namely imposing excessive inflation
on Germany. That sounds like a strange subject today, but that
very fact, I think, is something for which I have to give the
ECB credit. Also, we always knew that a multinational institution
like the ECB could not avoid some awkward compromises. We see
awkward compromises, for instance, in the ECB strategy between
the inflation targeting approach and the money-supply target approach.
We see apparently another awkward compromise in the proposed voting
reform, the compromise between what you could call technocratic
efficiency, which would call for a small group of experts taking
the interest rate decisions, and what you could call the legitimacy
of the multinational institution, which in the extreme would call
for the one-country one-vote system. The real question is whether,
given the probably inevitable nature of making such awkward compromises,
the compromises or trade-offs have gone too far against efficiency
or not. In that sense ultimately we can only judge the ECB by
results. Looking at their performance in terms of their major
goal, price stability, they have delivered inflation roughly around
two per cent, not very far from what they said they should be
doing. So in that sense I must say the ECB does not score too
badly, whatever in detail the criticisms now are. Also I would
like to emphasise that probably the nature of the trade-offs that
have to be done changes over time. Initially, you may want to
be close to the old Bundesbank model to get their credibility;
initially, you may want to be close to the one-country one-vote
system. But, as the bank acquires credibility on its own over
time and legitimacy with the population in the nations at large
within the monetary union, then over time probably the balance
of arguments could shift more in favour of technocratic efficiency.
Thank you.

62. Thank you very much. Professor Thygesen?
(Professor Thygesen) Thank you, my Lord Chairman.
The European Central Bank has existed for four and a half years.
On the whole I think one has to say that it has performed as well
or better than those of us who were positive in our assessment
expectedand I was never a euro-sceptic like my colleague.
It has in particular delivered inflation at around two per cent,
which I think is a highly desirable outcome given the disturbances
we have seen over the past four and a half years. Inflation has
fluctuated somewhat in the euro area between just less than one
per cent in 1999 and a bit more than three per cent in the first
half of 2001. But inflationary surges which came largely from
factors that could not be controlled were subsequently dampened
by cautious policy of the ECB, and I think the ECB can rightly
take some pride in the strategic review it has recently made in
saying that over the medium termif you interpret that to
be the four and a half years that we have now seenwe have
delivered inflation at just under two per cent or very near two
per cent. I see the strategy review in a sense as confirmation
of what has been done so far, a continuation of performance, but
some improvement in the formulation of strategy, which does address
the concern that many have had in the recent period that two per
cent might be a bit low or not having a more explicit lower end
to the inflation objective could imply some danger of deflation.
I do not think that is highly topical. I think that we should
also take some comfort from the fact that on two occasions in
the past, in the first six months of the ECB's existence and again
in the fall of 2001, the ECB did cut interest rates at times when
this was not strictly warranted on the basis of its own criterion,
the monetary aggregates. They did so since they were concerned
about deflation or low growth in Europe. There was a reference
certainly in 1999, which may be the closest analogy to the present
time, to sustaining Europe's potential for growth. So I think
on the whole the system has worked well. I share many of the academic
criticisms that have been made of the ECB and by financial sector
economists that their communication strategy has left something
to be desired: it has not quite had the transparency and the clarity
of the ECB. Some of that is due to the factors mentioned by Dr
Schmieding, the complexities of an international institutionand
that is the reason why I have not favoured going all the way to
transparency in the form of attributing votes and opinions to
individual council membersbut I think the ECB has now also
improved on the transparency side. It has to be accepted by national
policy makers that there are special considerations when you have
an international institution, that you cannot put all the pressure
on individual members of the governing bodies. I share the view
of Dr Schmieding on the proposed change in the bank. In my view
also there has been insufficient attention to the efficiency consideration,
which would certainly have made it desirable to move to a smaller
size governing council of the ECB than the 21 that is now envisaged
for the medium term future. That is too large a body, I think,
to have effective decision making. Thank you.

Chairman: Thank you very much.

Lord Sheldon

63. What interests me particularly is the body
that is ultimately responsible for setting the targets on interest
rates. We have of course in Britain the Monetary Policy Committee,
as you will know. Should there not be some sort of overarching
body that is responsible to look at the range subject to the changes
in circumstances? It is all right as long as the circumstances
have not changed, one can go ahead, but, if things do change in
the economic and financial field, there needs to be some sort
of outside body I would have thought that looks at this and makes
recommendations. How do you see the possibility of such responsibility
being put on an outside body.
(Dr Schmieding) I think this for the ECB would be
a very big revolution which probably would be like two steps ahead
of what we may expect in practice to achieve politically. So there
are two questions. The first question is whether it would make
sense from what I would call the technocratic point of view and
the other question is whether we can realistically expect to move
the political discussion into that direction in the foreseeable
future. As to whether it would make sense, it seems to me that
the verdict is a bit open. I have no clear opinion on whether
an MPC type committee, with outside members, is preferable to
a small committee of insiders, say an enlarged ECB executive board.
The outside members do bring outside experience, which is welcome,
but I would suggest that we could get roughly the same effect
by appointing academics and other outstanding personalities to
the executive board in the first place. On that, I think, the
evidence is not yet in to see what type of small technocratic
committeea UK style MPC with outside members plus insiders
and a mere inside body and a large executive boardis preferable.
The other question is whether an MPC-type approach with outside
experts is something that could be politically feasible in the
foreseeable future. There I think that this approach, taking just,
say, a few members of the executive board plus some outsiders
is such derogation, of the powers of the present National Central
Bank presidents or governors, who are appointed nationally, that
I think we will need further other reforms, step by step, curtailing
this kind of national influence on the ECB before we can think
about proposing such an ultra-integrationist, if, probably technocratically,
rather efficient approach.

Chairman

64. Before you answer, Professor Thygesen, I
do not think actually that was the question Lord Sheldon asked.
(Dr Schmieding) I am sorry.

Chairman: He was relating his question to the
fact that in Britain we have the Chancellor of the Exchequer who
tells the Monetary Policy Committee what its broad, basic objective
should be.

Lord Armstrong of Ilminster: For inflation.
Not for interest rates.

Chairman: For inflation. I think his question
was, was it not: Does the lack of this, the fact that the ECB
sets its own . . . Is that the point?

Lord Sheldon: That is right.

Chairman: It is not about whether there are
outsiders on the decision-making body about interest rates. I
am sorry for interpreting but I think it is important not to have
this discussion go in the wrong direction.

Lord Sheldon

65. Thank you. You are absolutely right, but
can I just add something to this. The bank has done very well,
as long as inflation was the problem. It is possible that in the
future that may not be the only problem and the question is: How
would the bank deal with the emergence of a new problem that requires
perhaps dealing with deflation. This is the argument for having
some other body that can advise on these wider issues.
(Professor Thygesen) If I may come back to the question
again. I think there is some evidence that the ECB is not unconcerned
with poor growth performance in the euro area. As I mentioned
before, they did cut interest rates in the spring of 1999 by half
a percentage point at a time when growth was slowing and the inflation
rate had dropped below one per cent. They acted again to stimulate
activity, certainly to show solidarity with the US Fed, after
September 11, 2001, also at a time when inflation was running
well above their target. So I think it is not quite fair to say
that the ECB is unconcerned with the underlying performance of
the economy. But of course they have a mandate that is in a sense
a lexicographic mandate. They have to look first at the inflation
rate and then, if there is room for stimulating activity, they
would do so. I think we are approaching a situation now where
that is certainly one of their concerns. I am not sure it would
help that much to have an outside body. Mostly the ECB is not
working in isolation: they read the financial press, they have
contact with academic economists, I must say, from the viewpoint
of academics, and I admire the way of getting ideas and suggestions
and having discussions with them. So this works. I should also
remind your Lordships that the ECB is somewhat different from
the Bank of England. It does not really have operational responsibilities.
The six members of the board are largely an analytical group that
prepares decisions for the governing council of the bank and in
that capacity they are also capable I think of showing some dynamism.

Lord Taverne

66. Is there any point in keeping the monetary
pillar? Very sensibly, the bank has disregarded the signs, the
direction in which that was pointing in the past. You yourself
gave the example of cutting interest rates at a time when the
growth of money supply suggested it should not. Is there any point
in keeping it? I know for the sake of saving face it still pays
lip service to it but in practice does it not ignore it?
(Professor Thygesen) I think the ECB has taken some
steps to downgrading the monetary pillar with the recent strategic
review. They have scrapped the so-called reference value, which
led to a lot of speculation in the markets: why should they now
try to raise it, because the demand for money was really higher
than was justified by the reference value, and, if they did not
change it, why not. It led to a lot of rather destructive discussions.
Taking that away, I think, is an important step, as they are now
doing. They are not reverting to fixing a reference value each
year. They have also stressed that the monetary pillar is on a
somewhat different footing from the more inflation oriented second
pillar. It has a longer time horizon. It is now called not a monetary
pillar. We have the monetary analysis which looks further ahead
than the horizon of one and a half, maybe to two years. The ECB,
as a third step, are beginning to look more at what are the causes
of the growth of the stock of money, reviewing credit to the private
sector in particular. That variable I think has some justification
as a supplementary longer term indicator, along with asset prices,
for houses in particular. So I think it is too much to say that
the monetary pillar has been scrapped, but it has been modified
in a way that seems reasonable and could open up, in a sense,
for an intelligent longer term framework for monetary policy.
(Dr Schmieding) On the role of monetary aggregates
in this old first pillar, there are two basic issues. First of
all, whether there should be a separate pillar for the monetary
and credit numbers, and the second issue is of course whether
money matters. On the second issue most economists would say that
money indeed matters for the long-run inflation trend. Also, credit
especially matters often for judging whether asset markets, the
equity markets, the housing markets, may be approaching a bubble.
As such, bubbles typically go along with an excessive rate of
growth in credit. So money very much matters. But it matters more
on the longer term horizon; it matters less for the near-term
business cycle outlook and thus for the immediate inflationary
pressures which may be facing the Central Bank four quarters down
the road. In that sense I think the ECB has done a step in the
right direction by emphasising that money is now a long-term concern
and money is used to cross-check the information from the other
pillar rather than something which is a pillar on its own. So
I think the ECB has gone in the right direction but I think it
would be better if the ECB were to go further. The ECB should
leave the old Bundesbank model, the time-honoured Bundesbank model,
further behind and come to what one could call a unified assessment
of future inflation prospects in one rather than two pillars.
As to the importance of money, one may need to add that of course
the ECB has, as you said, ignored the information from money supply
to some extent and has overshot the reference value for a long,
long time. The old Bundesbank used to miss its money supply target
on average every other year. So we are getting to where the technocratic
efficiency arguments are leading us, we are getting there step
by step at the ECB. Could I briefly come back to what the first
question was, Lord Sheldon, whether there should be a non-ECB
body to set the inflation objective. First of all, in a historical
context we have to understandand I see that very much in
the Bundesbank traditionthat the concern was to safeguard
price stability in a system where no longer the Bundesbank was
in charge. That explains why so much emphasis was put in the treaty
on price stability being the objective and something which could
not be changed as an objective very easily; that is, without going
through the ratification process of amending the treaty. Now whether
this historic concern makes sense going forward, is a separate
matter. I would very much agree that it will be preferable ultimately
for the legitimacy of the project if there were a high body that
gave the ECB what the definition of price stability is; for instance,
around two per cent would still be defined as price stability.
But in order to counter concerns that politicians or, in the case
of the UK, pretty much one person could then change such a definition
at will, any future changes to such a definition of price stability,
or called an imposed inflation target on the ECB, would need a
highly qualified majority in an appropriate political body.

Lord Lamont of Lerwick

67. I would like to follow up on what Lord Sheldon
has said about inflation, whether the ECB is well suited in its
set-up to counter inflation. Because it seems to me that countering
inflation is not just a question of loosening an inflation target;
countering inflation, and deflation if it actually happens, goes
wider. It seems to me that there is a certain amount of denial
in the rhetoric of officials, although recently the denial has
begun to be ended and people are now talking about a high probability
of deflation in Germany whereas a year ago there was no prospect
of it. We have now had two months of falling retail prices in
Germany. Mr Duisenberg has said, "When I was governor of
the Central Bank of the Netherlands we had a certain amount of
deflation but it remained moderate and it will remain moderate."
Just quite how someone knows it will remain moderate, I am not
so sure. Germany is a very indebted country: household debt is
quite high, so the danger of deflation is obviously a serious
one. Mr Issing has, I think, encapsulated it very well by saying
there is no danger of deflation in the euro zone but possibly
only in parts of the euro zoneand of course Germany is
just a part, which is the problem: you cannot have an interest
rate set for Germany, you cannot have a policy just for Germany.
This is my question: Is not the real problem that if you did get
into a deflationary situation in Germany which would affect Austria,
which would affect Belgium, what you require is close coordination
between the fiscal authority and the monetary authority, and the
monetization of debt, perhaps the creation of money, and you have
got such an extreme version of independence in the ECBmuch
more independent than the Fed, much more independent than the
Bank of Englandand you have 12 governments to coordinate.
It seems to me that the whole set up of the ECB is brilliant from
the point of view you were describing, from the inflationary threat.
Were deflation actually to come, I am not sure it is at all set
up or equipped to deal with this.
(Professor Thygesen) I will leave the German scene,
I think, to my colleague.
(Dr Schmieding) Fine. If I may start with some thoughts
on that. First of all, you rightly point out that we have to discriminate
between the possible deflation risk for the euro zone and the
possible deflation risk for parts of the euro zonewhich
is where Germany nowadays is at risk. For the euro zone, as a
statement of fact I still think the risk remains fairly low, with
core inflation of about two per cent. We are likely to see a significant
fall in inflation there, probably to below one per cent by early
next yearhelped hopefully by lower oil prices. But, to
deal with any risk that this may develop into deflation, the ECB
from its present interest rate levels, I think, has adequate tools
left. They can cut interest rates aggressively and I gather from
them that they would be ready to do it if need be. Of course,
they would do it in their own way, which is on average one month
later than most outside commentators would recommend to do that,
as a reflection of their internal consensus approach. On the euro-zone-wide
issue I am not very concerned for the time being. Now coming to
some of the specific German issues. First of all, there is quite
a significant likelihood that headline inflation early next year
could turn negative in Germany largely due to lower oil prices
on top of the very strong euro and on top of the general weakness
of domestic demand. Whether that risks a deflationary spiral or
whether that is just largely a welcome gift thanks to OPEC for
delivering low oil prices, which is actually good rather than
bad for growth, is a separate question. A negative deflationary
spiral fortunately seems at least significantly less likely than
it was probably, in retrospect, in Japan say five, six, seven,
eight years ago. Germany is tightly integrated into the euro zone
and the EU economy. If the ECB were to meet its objective of keeping
aggregate inflation, say, close to two per cent for the average,
and you were still to get German deflation, say, minus 0.5 per
cent for Germany, then to get an average of two per cent for the
euro zone, the difference between Germany, minus 0.5, and the
rest of the euro zone would have to be almost 3.5 percentage points.
This is not impossiblethe difference at the moment is roughly
1.5 percentage points. But such a difference would imply such
a significant gain in competitiveness of German exports in a tightly
integrated region that the deflationary downward spiral from fading
domestic demand in Germany would after a short period of time
be offset, to a noticeable extent by rising foreign demand from
within the euro zone. There is a similar mechanism at work as
to the second aspect of deflation which is virulent in Japan,
namely the problem of the financial sector. The German financial
sector is so tightly integrated now, not into the euro zone but
into the EU legal framework, that the risks for the financial
sector as a whole are limited. If German banks were to failand,
please, this is definitely not a forecast of mine, this is just
what were to happen ifif German banks were for some reason
to encounter problems on the scale of the Japanese banks and thus
were to restrict credit to the domestic economy severely, as has
happened in Japan, then it would be much, much easier for UK banks,
for instance, or for French banks to enter the German market in
an established legal framework and offer the credits to the consumers
or to the businesses that should be offered on viable commercial
terms. A longer term artificial restriction of credit supply as
a reflection of the banking system being weak is much less likely
to develop in Germany than in Japan. Having said that, Germany
faces severe problems, structural problems. There may be periods
of negative inflation, there may be some signs of deflationthe
worse case scenario evolvingbut I think these problems
will be significantly more manageable than they were in Japan.
Returning to the euro aggregate level, I think, if the problems
were to affect the euro averages, the ECB would take action. Of
course, ultimately, you are right, any fiscal monetary coordination,
if it really were neededI think we are far away from the
point where it might be needed, but if it really were neededwould
be more difficult than in a nation state. On the other hand, Germany
as one nation state gains the benefits of this tight integration
which I have outlined before as a safeguard against deflation.

68. Is it really likely, with Germany taking
36 per cent of GDPsomething like thatthat you could
get the average of inflation up to the level required to strike
an average of two per cent throughout the euro zone? If prices
had fallen minus 0.6 per cent, say, in Germany, it seems mathematically
difficult.
(Dr Schmieding) For roughly a two per cent euro area
aggregate average you need almost three per cent inflation outside
Germany and then minus 0.5 within Germanyor minus a little
bit, roughlyto get to the two per cent average for the
euro zone as a whole. And this gap in inflation is what would
increase the competitiveness of German producers and thus help
to stimulate foreign demand. May I make another comment which
I did not make in my first reply. You talked about the danger
of excessive debt, high indebtedness, at a time of deflation.
This is very much correct, but I think it is not genuinely a problem
of deflation. It is a problem in general of unanticipated falls
in inflation rates; that is, the value of your debt is not eroded
by inflation as much as you thought, as the borrower, when you
made the contract. Then we have to see whether the scale of unanticipated
falls in inflation rates now may be worse than in the past. I
think past disinflationary periods, such as after some of the
oil price shocks and the case of Germany after the episode of
unification, were at least as bad in terms of inflations surprising
to the downside than they are now and than they would be even
if German inflation were to dip into mildly negative territory.
So I think this is a problem. But it is almost a normal problem
of the business cycle rather than a specific feature facing the
German economy now and not before.
(Professor Thygesen) The question raises a number
of issues. I share broadly Dr Schmieding's view that the way the
German economy is attached to the rest of the euro zone really
in itself imparts a stability that has not been available to Japan.
What has made the Japanese situation particularly vicious, I think,
is the interaction of falling prices at home and a tendency for
the yen to appreciate still. It was the shock of major appreciation
of the nineties that made it particularly difficult for Japan.
Probably there, I think, the implicit advice that was in the question
was that if only there could have been a better coordination of
monetary and fiscal policy then Japan could have gotten out of
its problems. I think we have to keep in mind the starting point
and the fiscal position in Germany now, and for that matter in
Japan at the time, was not really conducive to counting on a fiscal
stimulus to redeem the problems of deflation because the deficit
was already too large. I think the German public would be alarmed
if there were now efforts at coordination under the heading of
let us do a bit more on the fiscal side to stimulate activity.
I think the question about coordination is not quite as urgent
in Europe as it was in Japan and the solution to it might not
be desirable. I also have difficulty in seeing how you could get
two per cent inflation if Germany really had negative inflation,
but inflation is no doubt coming down towards one per cent in
the euro zone as a whole. The target or, the way you call it,
the aim of keeping the medium term inflation rate at two per cent
will imply that there will be from time to time one per cent inflation
in the euro zone, as we have seen in the past, and that may be
compatible with slightly falling prices in Germany. What has also
made inflation vicious in Japanand of course even more
so in the deflation of the thirtieswas that the fall in
prices was larger, much faster than the very modest decline that
may now be happening in Germany next yearit was in the
order in the thirties of about four per cent per year. In Japan
it is probably correctly measured quite a bit more than the one
to one and a half per cent that we see in the price statistics.
So I think there is too much analogy made with the Japanese situation
for various reasons. The main reason for deflation, in my view,
is of course attached to the exchange rate, because if we believe
some of the models we are looking at as economists a rise of 10
per cent of the euro in effective rate terms, would depress the
price level by something like one per cent over a period of a
couple of years, and that is of course something that will temporarily
reduce inflation quite sharply. I am sure the ECB is watching
that. Although they do not like any suggestion that they have
any responsibility for the euro exchange rateand I think
that is basically a correct attitudethey are obviously
concerned and well aware that this will require some offsetting
monetary action if the situation continues.

Lord Lea of Crondall

69. I would like to explore what I think is
an explicit assumption that the growth versus inflation trade
off is a fixed trade off and there is no way of improving the
growth and inflation trade offbecause of course over the
last 30 years there have been changes in the growth inflation
trade off. The reason I would like to explore that question is
that both in his paper and in this morning's comments Mr Thygesen
has talked about an interest rate cut "to stimulate activity",
as though it is axiomatic that we are in the business of, in some
cases, stimulating activity. That to me sounds as if quite reasonably
there is an implicit output growth target, an output growth idea
of an optimum in economic policy which is partly the responsibility
of the European Central Bank, albeit couched in terms of an inflation
target; in other words, that an inflation target is really in
part a proxy for an optimum economic growth target as well. Would
he comment on that? Likewise, Mr Schmieding, in the last sentence
of his paper says, "The decision to delay a rate cut can
hardly qualify as a second-best let alone a first-best solution
to the immediate needs of the euro zone to stimulate domestic
demand." There again we have the question: Is it part of
the remit of the European Central Bank to have such a policy to
stimulate domestic demand in some circumstances? If so, why, unlike
the Fed in Washington, is that not made explicit as part of its
remit and what is the efficacy of such a policy?
(Professor Thygesen) If I may start, since there was
reference in your Lordship's question to my note. We have great
difficulties in measuring what the output gap is in our economy,
how closely our economies are to working at capacity limits, and
there is some dispute, I think, between governments and the European
Central Bank as to where that balance currently lies. The European
Central Bank has a pessimistic but I am afraid reasonably realistic
view that most of the problems of slow growth in Europe have been
of a structural nature and that there is not really that much
room left for stimulus. The unemployment rate in Germany, for
example, is largely structural. There is not much significant
slack in the German economy. It is now developing, clearly. In
some other countries also that slack is less than it would have
seemed some time ago. In fact the growth rate of the economy has
slowedproductivity has been particularly slow. In these
circumstances, of course, the Central Bank is fairly powerless
to stimulate very much because the room for that is not very great.
I also note that still in Germany wages are going up at quite
a remarkable pace, given the situation that we find in the unemployment
figures, which also suggests that we are not so far from the limits
of capacity. The aim of the policy of maintaining a stable inflation
rate, let us say, of two per cent on the average over longer periods,
is of course also in that process to ensure that the economy grows
in the long term approximately at its natural rate but that natural
rate can be influenced by other policies. Governments are working
on those other policies which are of a structural kind. We are
finally seeing efforts in European countries, on the Continent,
to step up a rate at which their economies can grow. They are
proceeding slowly, but there are now some reforms on the way in
Germany and France which would make it possible that the rate
of growth could be a bit faster in the next few years than it
is today. Then it is, I think, the natural obligation which will
come out of the Central Bank's mandate to maintain a stable inflation
rate, and once it tries to maintain two per cent inflation in
that climate it has some space for cutting interest rates.
(Dr Schmieding) If I may briefly add to that. Of course
in an explicit inflation objective there is always an implicit
objective for the real economy, in the sense that the real economy
should, over a medium to long term, be kept at its growth rate
which we would call potential. Otherwise, if the Central Bank
were to overstimulate the economy, inflation would rise; if it
were to deliver insufficient stimulus, inflation would fall. So
in an explicit inflation objective, there is an implicit assumption
on the need or the objective for the Central Bank to try to keep
the real economy close to its natural rate. Whether growth should
be made not just an implicit but an explicit part of the remit
is what I would call either a question which does not really arise,
if we agree on what I said first, or a question which could politically
be dangerous. It might nourish a popular illusion that indeed
the Central Bank can do more than influence the short-term fluctuations
of the growth rate but that the Central Bank may be responsible
for the longer term trend rate of growth. Coming from this angle,
that it might be politically dangerous to nourish such an illusion,
I would come out clearly on the side of those saying there should
not be an explicit growth objective in the remit of the Central
Bank.

70. Could I ask a supplementary on that. Although
it may be politically misconceived to try to make the productive
potential explicitly one of the parts of the remit, it is an unfortunate
consequence of not having it as part of the remit, would you not
agree, that we are left in the position that the European Central
Bank is seen to believe or to operate on the precept that the
inflation rate is uniquely able to act as a proxy for all these
matters of productive potential and we are left in the positionwe
are in denial in this senseof saying anything about the
fact that it is a part of their job to try to make sure that Europe
grows accordingly to its productive potential, as long as the
overriding first priority of inflation, no more than about two
per cent, is adhered to. So the question still remains, whether
or not it is part of the remit, does it not?and the danger
of popular illusion, that all you have to do is put your foot
on the accelerator. Nevertheless, for many of the people that
I used to represent as a trade union official, for example, it
looked very strange that there was no explicit acknowledgement
that productive potential of the economy does not need to be looked
into at the same time as we have this overriding two per cent
inflation target.
(Professor Thygesen) I am not sure that it would be
productive to have any such explicit obligation for the European
Central Bank. I share the view of my German colleague and I still
point out that the Central Bank has acted in ways and times and
has tried to exploit what was seen as a faltering exploitation
of the actual growth potential. Raising the growth potential
really requires very different means of economic policythe
kind of structural reforms that are now finally under discussion
in Germany, France and Italy: labour market reforms, pension reforms.
They may only be fully effective if there is then some policy
that follows it up on the demand side, but we have to see the
structural policies be put in place first before I think there
can be any discussion of stimulating demand. In that context I
think it is particularly valuable that the European Central Bank
does have this clear explicit mandate of maintaining price stability.
This in itself should not be overlooked. It is a contribution
to growth in the long term by dampening fluctuations around the
economy's potential.
(Dr Schmieding) I think that almost all central banks,
including the European Central Bank, understand it as part of
their remit to avoid excessive fluctuations in economic growth
and, you could add, hopefully avoid excessive fluctuations in
asset markets. If we are not talking about growth, which ultimately
is a matter of the structural policies you referred to, if we
are talking about fluctuations, then we are leaving a bit the
dangerous territory but we are also coming to something which
for the central banks is very obvious. So I do not think that
there is a major need to make it as a part of their explicit remit
secondary to the overriding objective of price stability, and
I would probably consider it technically not easy to find the
wording which points in the right direction without giving rise
to any hopes that this might in the end compromise the attachment
to price stability.

Lord Marlesford

71. If one accepts that some of the overall
objectives of economic management are not to have inflation, to
have optimum growth, and, perhaps most importantly, not to have
recession or deflation, would you agree that the ECB is designed
really with the first of those in mind, the inflation, and that
indeed was its remit, and it has performed, as you have suggested,
pretty well in its first four years? But we are now moving into
a different world and there is a sort of discontinuity between
having an ECB which is able to fulfil a role that it is given
in the first world and the role in the second world, where the
role of the Central Bank on its own is much more limited. I was
rather struck with I think it was your paper, Professor Thygesen,
where you said "the weekly unrecorded breakfast meeting between
the Chairman of the Fed and the Treasury Secretary". There
is, it seems to me, a lack of overall responsibility for the euro
land EU area economic management. We have the Commission trying
to impose the stability pact, which has been shown to be pretty
inappropriate for changing circumstances, I believe, and we have
the individual governments striving to manage their own economics,
and yet we have an ECB trying to perform an overall role, we have
a single currency with all the implications of that, and somehow
it seems to me, and I do not know if you agree, that there is
a danger of what I would describe as internal contradictions emerging
over the coming period.
(Professor Thygesen) If I may start this challenging
question. Certainly at the time when the rules in the Maastricht
Treaty were written, the concern was inflation, excess demand,
very possibly lack of control of budgetary expenditures, too large
deficits. These problems have not completely disappeared. From
a long-term point of view there are some problems about fiscal
policy. In the long term perspective one can certainly question
whether the public finances of several of the major European countries
are sustainable. They show such growth in underlying deficits
that there are major challenges to the policy makers. I think
it would be more appropriate if they had attached considerable
weight to these problems instead of looking as much as they seem
to do at the short term. One should not underestimate that the
present machinery does offer a number of opportunities for monetary
policy makers to meet national policy officials and, indeed, for
the presidency and members of the Euro group there are similar
possibilities of contact. There are constant exchanges about what
is the appropriate policy mix. I do not think the system is quite
as far from the US system as your question implies, although there
is no weekly breakfast meeting. The persons there may have even
closer personal contacts, I would not deny that, but I do not
think the world is all that different from what the rules of the
treaty, including the stability pact, were set up to do. I think
some of the reticence of the ECB also to enter into any further
strengthening of that mechanism is due to these underlying imbalances
and the continuing concern, maybe, by national policy makers with
shorter term issues.
(Dr Schmieding) Yes, you are right, the ECB statutes
were devised in a different situation. We may or may not be moving
to a different worldat least the subject of deflation is
much more frequently mentioned than before. It is of course among
the reasons why I would prefer an explicit symmetric inflation
target for the ECB, say around two per cent. The symmetry already
signals that both risks to the upside and to the downside are
to be taken into account with equal weight if they were to arise.
In practice, of course, the ECB has kept inflation pretty close
to two per cent, most of the time actually slightly above two
per cent, so I am not sure whether the move to what I would call
a clearer rhetoric, namely a two per cent symmetric target, would
for practical policy make a significant difference. On the second
aspect, the coordination of the monetary and fiscal coordination,
I find some of the arguments for such coordination theoretically
rather compelling for an optimal steering of, say, the economy
short term. My experience, which largely is grounded in a few
countries admittedly of central Europe, is that politicians find
it very, very difficult actually to commit to that and to keep
their side of the bargain. It is very easy for the Central Bank
the next week to act on interest rates. It is much more difficult
for fiscal policy to actually push the laws through Parliament.
Largely for practical reasons I think we should not expect much,
if anything, out of monetary-fiscal coordination. In a European
Union context one general problem of fiscal monetary policy coordination
would be exacerbated. Fiscal policy tends to run on its own election
dictated cycle with any tightening, if possible, coming after
the election and any loosening ahead of the next election. That
may or may not by accident meet the requirements of the business
cycle, but it does not lend itself easily to coordination with
the Central Bank even on a national level. Trying to achieve such
coordination with 12 or even more governments who uppermost in
their minds, and rightly so, have their own legitimacy and their
prospects of re-election, is not a very easy proposition. Thus
for practical purposes I would stick with the approach and possibly
improve on it: keep each other informed as much as possible about
what fiscal policy may be up to and what monetary policy may be
up to; but do not try to rely on any explicit coordination.

Chairman: After Lord Armstrong, I think we will
switch to the structural problems of decision-making and also
the questions of transparency and public presentation policy.

Lord Armstrong of Ilminster

72. I think Dr Schmieding has probably answered
the question I was going to ask, whether our witnesses would like
to see the inflation target for the ECB expressed as a range?
I think Dr Schmieding was saying he would like to see a symmetry.
If that view was accepted, what should that range be? We are told
by Professor Issing and Mr Papademos that the aim would be inflation
close to two per cent from below. That suggests that the range
might be from one to two per cent or possibly 1.5-2.5 per cent.
Could you comment on that?
(Professor Thygesen) I do not think there is all that
much difference between the past practice of the ECB and following
such a rule. The actual policy of the ECB could be described by
the policy of keeping inflation within a one to three per cent
range, as has happened in the first four years. So the two per
cent on average in the medium term already gives flexibility to
the ECB management. The range I think may give an undue element
of precision to the idea of a target. As soon as you are somewhat
away from just below two per cent you begin to react more and
more as you are driven away from it. There is no particular range.
I do not see any great harm in that. It does not necessarily increase
accountability. I know this is a new area in this country. The
Bank of England has 2.5 per cent minus one per cent. The ECB might
move to that in the longer termI am not sure. I do not
think it would make much difference.
(Dr Schmieding) I would very much agree with that.
I think an explicit symmetric inflation target is preferable,
but I would call it preferable on grounds of rhetoricpreferable
in terms of making it easier to communicate with the public. I
share the view that it would not have made any difference to the
actual decisions by the ECB which, judging by results, have indeed
been to keep inflation at roughly two per cent, rather than trying
to do everything to either get inflation below two per cent or
actually to get money supply growth closer to the 4.5 per cent
reference level.

Chairman: I suggest we look at the subject matters
of structure and the new decision-making arrangements for an enlarged
European Union, and presumably at some stage an enlarged euro
zone, and also at the issues of transparency and public presentation
of policy, which go together.

Lord Geddes

73. Thank you, my Lord Chairman. I would like
to concentrate on the former at the moment and let some of my
colleagues concentrate on the latter. We have, as you know, had
evidence from other witnesses. I would particularly like to hear
both our witnesses this morning give their opinion on the optimal
solution as far as the Governing Council is concerned when enlargement
comes through. Could we also hear your opinions, in the plural,
of the relative size of the roles of the Executive Board relative
to their Governing Council?
(Professor Thygesen) The optimal size, I am afraid,
is by now a somewhat moot question, because we have a recommendation
from the ECB Governing Council which has been endorsed by the
European Council and I do not see any prospect of changing that.
I regret there was not more discussion of it in public and not
in your country or in my own which is also outside the euro area.
Obviously it was a very difficult compromise to try to reconcile
the basic idea of democratic legitimacy with efficiency. The issue
was one man one vote and efficiency in decision-making. Initially
I thought they had gone too far in satisfying the former and without
gaining too much in efficiency because the size of the Governing
Council could still go up to 21 members15 plus six, and
I come back to the question of the size of the Executive Boardwhich
is even larger than the one today of 18. I think this does raise
serious questions of concern. It will make it more difficult for
the Council to function in the way it has done so far, largely
by gradual consensus-building. There have been very few instances
of any votes in the Governing Council. With a very large membership
there is always a danger that coalitions could build up. This
has not been obviated by this particular proposal; that would
still be possible although slightly less likely of course than
if every country remained with one vote. It is mainly a question
of the efficiency. In a way it is also a problem that all national
central bank governors, whether they currently vote or not, will
be participating in a discussion which will take a form more suited
to a parliamentary debate than to a decision-making forum on interest
rates. It is more difficult for the Executive Board to maintain
its coalescing role in such a large party. I am concerned about
that. My own idea would be to move towards a much leaner structure
and give more decision-making authority to the Executive Board
itself with the Governing Council in full composition having a
quarterly role as an assembly that gives general guidelines for
monetary policy but does not month by month sit down in Frankfurt
to take votes on interest rates. I do not think that is particularly
desirable. I understand why this compromise has been entered into
and I know it was difficult to arrive at it. In that light one
can always discuss whether it is reasonable to redress this imbalance
and increase the Executive Board somewhat to offset its relative
decline in the total Governing Council. I do not think so because
the Executive Board does not have all that much to do. They have
a few operational tasks and six is quite adequate for the functions
they handle at the Board. I would have preferred to go the other
way. That is, I am afraid, not very feasible in the short-run.
(Dr Schmieding) This is, indeed, a very, interesting
and difficult question. Let me first start out as an academic,
not looking at the political context. As an academic I would come
out on the side of those saying it should be a small committee
of up to nine members to serve for a fairly long time. You could
say possibly an enlarged Executive Board of the ECB that takes
all the decisions month on month on interest rates. This might
be guided by a larger body meeting occasionally. That is the academic
optimum, I would say. The next question is the political question.
I would like to emphasise that this touches on core issues of
the perceived legitimacy of such an arrangement. It is easy to
imagine a situation where by accident, say, all European Nobel
Prize winners in economics were to be from France. If one were
to pick the best experts to serve on the ECB Executive Board,
one may have to say there should at least be three Frenchmen or
Frenchwomen on there in such a case. We are getting into very
tricky terrain here the closer we get to the academic optimal
of picking a small number of the best suited experts for the task.
Especially in the initial stages, we have to ensure that the legitimacy
which national central banks enjoy, hopefully, in their own country
is transferred to a supranational body. We should think very hard
whether for the sake of preserving such legitimacy for quite a
while, until the ECB has gained legitimacy by its track record
rather than by consensus, we should accept deviations from what
I would call "technocratic efficiencies". I can understand
in this context how the debate has evolved, and how the ECB has
come up once again with what I would call an "awkward compromise".
The next questionagreed that it is an awkward compromise
on which as an academic (or with a bit of an academic record)
I would find it easy to improve onwhether this is indeed
harmful, leads to a very different debate. I think that interest
rate decisions especially are rather clear-cut yes or no decisions.
You either cut or you do not cut next Thursday by 25 or 50 bases
points. After a long arduous debate, the matter can easily be
settled by a vote; and can almost be as easily settled by a vote
among 21 members or 25 members rather than nine, 15 or 18 members.
What the awkward compromise entails is more an internal problem
for the ECB, namely that the actual debates, with so many people
having the right to speak and many of them in the future retaining
the right to vote, complicates and prolongs the debate. I am not
sure that it will have a significant impact on the outcome of
the debate. One could actually argue that enlargement, regardless
of how precisely it happens, in adding to the number of people
who are entitled to speak on interest rate decisions, may even
speed up such decisions. The present practice of the ECB is to
try to form a consensus, which is very understandable once again
for historic reasonsthe ECB does not want its decisions
to be seen in terms of one country outvoting the other. But with
ever more members being entitled to speak and vote than in the
past, it is quite easy to imagine that the larger group may agree
to vote on interest rate decisions one month before the smaller
group would have found consensus. It is an important issue. But
for practical policy decisions, as opposed to how difficult it
is for the ECB and the internal debate to actually get there,
I do not think that the proposed enlargement of the ECB council
will make a crucial difference. Thus I have some sympathy for
those who say, "If it does not make a crucial difference
on the actual policy, we should for the time being preserve some
element of national legitimacy".

Chairman: Could I ask that in the next exchange
you should include within it perhaps some comment on the public
presentation policy, transparency and so on.

Lord Taverne: I think my question has been answered
pretty comprehensively. I hope that Dr Schmieding's more optimistic
version prevails. If it does not and discussions are interminable
and decisions are compromised, that sufficient pressures can be
generated to come to a more workable conclusion and to allow the
technocratic element to play a bigger role. However, I think the
question has been pretty well answered. I favour moving on to
the transparency aspect.

Chairman

74. May I suggest that one solution is to do
what the United Nations Security Council often does, which is
to take the decision before you have the debate! Perhaps you could
say a little bit about the question of public presentation of
the ECB's policy, its track record in doing that and possible
ways of improving itwhether that is by publication of minutes,
publication of votes. You know the menu is rather well known and
has been devoured by the many experts, academics and others, but
it would be interesting for the Sub-Committee to hear your views
on those points, even though I think we all recognise that they
are second order points and not ones we should assume actually
make a huge difference between a successful ECB and an unsuccessful
one.
(Professor Thygesen) My Lord Chairman, we are talking
about a moving practice on the part of the ECB. Communication
is improving. It has rightly been criticised over a few years
on several occasions. It is true the ECB has always published
a lot of material and some of that has been out in the public
domain earlier than those central banks that are proud of publishing
the minutes and records through the press conference of the ECB
President. Of course, that kind of practice does not give the
full flavour of the debate. It is not a full substitute for it
and may tend to become too defensive, with the decision taken
not giving sufficient weight to the whole discussion that was
behind it. That is a matter of the actual skill of the President
and his colleagues in presenting that. On the whole the markets
seem to have better anticipated and understood the ECB's action
over the past year. They may have been unhappy that action was
not taken earlier on a couple of occasions but, on the whole,
they have understood and been sympathetic to the explanations
given by the ECB. The problem has improved over the past year
or so. Could it be improved further? Yes, certainly. Explanations
at press conferences could become better. The monthly bulletin
could be further enlarged, although it is already quite rich.
The use of the work of the staff, the staff forecasts, might be
a bit better integrated into the presentations and more emphasis
could be given to that part of the Bank's work. On the whole,
I think it is a process which is improving and is recognised as
such by the people to whom it is most important, namely those
who are in the financial markets.
(Dr Schmieding) I think that the more the institution,
the ECB, acquires its own gravitas and track record over time
the easier it will find it to become more open to publish the
minutes, to publish the votes. I have sympathy for the initial
natural inclination to say, "We are a new body. We have to
find our own rules how we, representing 12 nations now, come to
a conclusion, and we do not want every journalist and politician
to peer over how exactly we do this". That is a valid argument
not forever but only for the initial stage of establishing the
internal culture. In the longer run there is indeed a risk that
the internal culture evolves too far from what the public would
like to see. Over time the arguments for more transparency will
become more forceful. Ultimately the ECB should be told that eventually,
possibly in a process in stages, it should start to publish votes,
if there are votes, and start to publish minutes, and then start
to publish who actually said thingsthat is, attributed
minutesand, in the end, attributed votes. This I think
is something which is and should remain step-by-step on the agenda.
It is a legitimate demand of the public that that should eventually
happen. One further small side comment on the Council reforms.
My optimum action at the moment, as the Intergovernmental Conference
will take up the issue of the ECB Council reform anyway in the
coming years, would be to insert a new clause saying that three
years after 15 countries are in the monetary union, so that the
new procedures are starting to bite, the ECB is instructed to
come up with an unanimous proposal on how to reduce the number
of people actually talking and voting on interest rate decisions.
But one should not to impose that at the moment.

Lord Lamont of Lerwick

75. One of the things which has not been commented
on very much is the way in which the larger countries hitherto
have carved up the Executive Board and you have a rotating position
for the Finns or the smaller countries, but in effect the French,
the Germans (and I think the Italians) have managed to get two
members. Do you think that is right, given that we are not meant
to be having national representatives? Why should Germany have
two representatives on the board?
(Professor Thygesen) They do not have two representatives
on the board.

76. They did when you count the Executive Board?
(Professor Thygesen) With the Board member and the
Bundesbank President they have two.

77. They effectively have two votes.
(Professor Thygesen) So have Finland and the Netherlands.
They have also had two votes in the past four and a half years.

78. That is because Mr Duisenberg was the President.
What if Mr Duisenberg had been replaced by Mr Trichet?
(Professor Thygesen) In the meantime we have exceptionally
had three nationals of smaller and three from larger countries.
But normally, a 2:4 balance between the smaller and the larger
countries has been rather reasonable in terms of the economies
within the euro area. There is no written rule. We have seen in
particular circumstances France has currently had no member on
the Executive Board, in the hope it would have the presidency.
There is no fixed rule and I think it has to be left flexible,
and has been left flexible  also with a view to seeing
if the UK were to join and what it would then be like.

Lord Lamont of Lerwick: It is a carve-up with
France and Germany, and they did not have a vice president because
they expected Mr Trichet halfway to step in. The theory is that
France and Germany have two votes.

Chairman: I am not sure it is the votes that
is interesting, it is the appearance. There is one other structural
aspect which Lord Geddes would like to address which I think relates
to the decision of appointing the President or Chairman of the
Bank, not a very happy occasionthe only occasion on which
it has happened. Is there any way you can think of (and I choose
my words carefully) so a future "botched job" can be
avoided? It certainly does not seem to me it is at all desirable
that the European Union should slip into a period of divided mandates
and things like that, which is better known in the UN Security
Council and has not produced very good results there either?

Lord Geddes

79. You have virtually asked my question, my
Lord Chairman. I will just add a little flesh to it. You have
got the Commission, the European Council, the European Parliament
and national parliaments. What should be the role of each of those,
if any, in appointing a President and other members of the Executive
Board?
(Professor Thygesen) I think that the current procedure
is not really that bad. What happened in the appointment of the
first President was possibly that the central banking caucus took
the matter too far and had reached an opinion without having sufficient
input from the political side. It has to be recognised there has
to be a strong political interest in this nomination. The European
Central Bank is such an independent creature that the nomination
of its president is a political prerogative and must be preserved
in political hands. Maybe there was too much consensus among the
central bankers before it reached a political level and then some
reservations arose. It would certainly be desirable to avoid similar
situations in the future. I think there should be no obvious role
of the national parliaments in looking at this particular nomination.
The European Parliament has and will retain this European role
in having very elaborate hearings with candidates for the whole
Executive Board, in particular with the president. That, I think
is a reassuring practice. The European Council nomination, no
doubt discussed carefully first in Ecofin or the euro group and
consultation with the ECB, has to have a collegiate element in
it also. That would be my view.